Is ESG investing a scam?

ESG has become one of the trendier ways to invest in recent years, with investors and financial institutions alike recognising the appeal of generating returns while doing some good in the process. However, a wave of criticism has been directed at the strategy recently: while some accuse those selling ESG funds of ‘greenwashing’ their products, others are sceptical that actual ‘green’ products can generate the same returns as conventional investments. With ESG investing in the hot seat, investors are wondering whether the critics are right: is ESG a deceptive and ineffective scam, or does it reap the benefits that it claims to?

ESG stands for ‘environmental, social and governance’. Within ESG investing, these three criteria are used as metrics to assess how sustainable an investment is. The demand from investors to offer more ESG-embedded products has shot up in the past decade as the younger generation’s focus on sustainability has gained more influence in the financial markets. Indeed, according to the EIU, 76% of younger generations in the UK say they would consider ESG factors when making investment decisions, compared to 37% of older people. However, ESG investing seemed to be blossoming across the private investing industry in its entirety in 2021, with the Investment Association finding that over 33% of net inflows into UK retail funds went into ‘responsible investment’ products. Most financial institutions have responded eagerly to this increased demand for sustainability, with nearly all committing to a net-zero emissions target by 2050 or earlier and increasing their incorporation of ESG metrics into their investment products and recommendations. As portfolio managers who embraced sustainable investing started to significantly outperform their peers, and investors started to benefit from greater returns, the ESG financial industry began to boom. So, what changed?

Until recently, it seemed ESG was the way forward in investing, offering profit with a purpose to both sellers and buyers. But with ESG stocks nosediving in 2022, we’ve been left to wonder: what went wrong? Well, it seems to be a growing opinion that there is a lot wrong with ESG. Elon Musk has called ESG a scam, while two former BlackRock executives resigned from their sustainability roles after failing to see its value. Meanwhile, many authorities are cracking down on ESG, with German Police raiding the DWS Frankfurt offices and the FCA proposing tighter UK regulations on the classification of ESG funds. This backlash has come as increasing scrutiny has been placed on the greenwashing of products by investment managers, where claims are made that products are green when in reality they are not backed up by sufficient sustainability standards. Indeed, many ESG funds are rife with unsuitable investments in the fossil fuel, tobacco and alcohol arenas, and yet are still marketed as sustainable by their sellers. Therefore, it is no surprise that experts in the field are increasingly calling out the deception underpinning the ESG investment industry, with many explaining how investment managers are misleading investors into purchasing products they would otherwise cower away from in order to fulfil their own agenda: maximising their stake.

However, Alan Miller thinks the blame lies with ESG regulators rather than financial institutions. The successful UK asset manager criticises independent rating agencies for allowing ESG funds to hold unsustainable ‘sin’ stocks through rating these stocks as ESG-friendly: for instance, tobacco company BAT is the third-highest ESG rated company within the FTSE100 according to the agencies.  This has allowed funds such as such as JOHCM UK Equity Income, which is valued at £1.9billion, to be characterised as having sustainable characteristics despite its two largest holdings being BP and Glencore, the latter a mining company that has recently been fined for exploiting African regulators. When news broke that the FCA was formulating new rules for ESG branding this year, some speculated that it may ban sin stocks from ESG products. However, this has not been the case. According to new guidelines, fossil fuels will still not have to be excluded from products in order for them to be classed as sustainable, but rather managers will have to explain why these assets are suitable to incorporate into the funds.

While you may find it strange that investment managers are so keen to retain sin stocks in their ESG funds, and even stranger that regulators are reluctant to ban them, there is in fact a very simple explanation for their inclusion. Without these stocks, ESG funds are currently less profitable, making them less attractive to investors and ineffective in their agenda. While funds aligning with ESG criteria experienced exceptional financial performance for many years, they have been hit by a market downturn this year, with Refinitiv Lipper reporting net outflows of $108billion globally.  Factors including the demise of the environmentally friendly tech industry this year, which the ESG industry is heavily exposed to, alongside the rise in value of oil and gas stocks amidst the energy embargo on Russia, have caused investors to pull out of ESG investments faster than general market funds as they seek better returns elsewhere.

The recent poor performance of ESG illustrates one of its key weaknesses: although investors are interested in investing responsibly, they are not prepared to do so at the price of weakened returns. Experts fear this may highlight a significant limit to the potential of ESG investing if its impacts on improving global sustainability are dependent on the guarantee of superior returns. Therefore, ESG investing faces an impossible dilemma: does it continue to include profitable -yet unsustainable- stocks within portfolios at the risk of greenwashing, or does it eliminate these stocks at the risk of diminished returns? Currently, neither of these options allow ESG to be a catalyst for change in the quest for sustainability.

Looking into the future, there may in fact be a solution to this problem. Mr. Keeley, an ex-asset manager at Blackrock, argues that instead of funnelling money towards sustainable but less profitable companies, the focus should shift onto investing in companies with persistent ESG issues on the condition that they make an effort to change. Not only would this solution allow ESG products to become more competitive and facilitate the industry’s growth, but it could help to increase its contribution to sustainability through targeting the companies that do the worst damage. Mr Keeley’s idea is reflective of the huge levels of thought being put into reforming ESG, and offers testimony to the fact that many professionals do recognise its potential and are keen to strengthen it against the claims that ESG investing is ‘selling the public a wheatgrass placebo as a solution to the onset of cancer’, as Blackrock’s ex- global executive officer of sustainable investing, Tariq Fancy, put it last year.

Regardless of the way we move forward, it is clear to everyone that ESG investing is here to stay. After all, issues such as climate change, waste management and employee treatment are becoming increasingly material risks that need to be assessed when investing. Moreover, these risks often also present excellent investment opportunities in fields such as renewable energy, which according to the IEA will generate 90% of global electricity by 2050. However, as ESG becomes an increasingly integrated part of our investment framework, there is a growing concern regarding how to minimise its deceptiveness and effectiveness: in order to maximise the benefits it can bring to the sustainability movement, ESG investing is in need of a rethink.

Image: Akil Mazumder on Pexels

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